The Cobden Centre

This article was previously published at GoldMoney.com.  For an explanation of the different Austrian measures of the money supply (AMS, TMS, and MA), see the recent paper from Kaleidic Economics,  “An introduction to a new measure of the money supply: MA” (PDF).

With all the troubles of Europe hogging the headlines, commentators are ignoring money supply in the US, which is growing strongly, with the broad measure of M2 growing by over 10% for the last 12 months. Furthermore, the annualised growth rate over the last six months has been above 15%. The story told by the True Money Supply confirms this.

The reason for using TMS is simple. According to the Ludwig von Mises Institute, it represents the amount of money in the economy available for exchange. Furthermore, it is designed to clearly show any expansion that results solely from central bank injections of cash and commercial banks’ credit creation, by excluding anything that has to be converted into cash first, such as credit and money market funds. It is therefore a pure measure of money in the economy available to be used for transactions, more pure than official MZM, M0 or any other central bank “M” measures.

In economic theory this is important, because money is simply a commodity that happens to be used exclusively as a medium of exchange. And as a commodity, its value ultimately depends on its supply and the demand for it. By using TMS we keep the relationship between actual money and prices pure from other arguable factors.

The growth in US dollar TMS over the long-term is shown in the chart below. From this chart it can be seen that following a pause in its long-term trend at the time of the 2007-08 financial crisis, TMS has been growing strongly ever since.

The bulk of the growth has been in check deposits (customer current accounts) and savings deposits (instant access accounts) at the banks. Some commentators point out that this reflects cash not being spent and cash representing risk-averse hoarding. But this opinion ignores the fact that the cash is being used, because the banks have lent it to the government, and the government is distributing it into the economy.

So this cash does amount to extra supply of money, which will be gradually reflected in a fall in its purchasing power. Given that the acceleration in TMS dates back to 2009, we are already seeing this, with ShadowStats.com, which applies an unbiased statistical rigour to key statistics, estimating actual inflation to be running considerably higher than official estimates.

The other aspects (other than of money that is) of the pricing effects of supply-and-demand is the variability of demand for individual goods. And here, the picture – as always – is uneven. Welfare, defence and healthcare spending by government maintain demand for energy, food, defence and healthcare-related items. Banking and related financial services are also doing well, despite balance sheet problems, as they are closest to the source of the new money (in this case, the Federal Reserve). Much of the rest, as business surveys and unemployment statistics confirm, is patchy at best. So there are identifiable winners and losers in pricing, and the expansion of TMS is feeding through to those goods, demand for which is supported by government spending.

With this monetary background, it is likely that the big headache for 2012 will be persistent and rising price inflation for the US and other economies tied to the dollar. So we can expect stagflation to be in everyone’s vocabulary in the New Year, which will inevitably lead to pressure for interest rates to rise sooner rather than later.

Previously published at GoldMoney.com …

What would you like to see as a solution – albeit perhaps imperfect – to the Greek debt situation?

Sean Corrigan: What I advocated as soon as the last credit bubble burst was exactly what is now being slowly accepted as a sine qua non – that debtors who over-extended themselves in the Boom must renegotiate with creditors – who were, conversely, too glib about the risks they were taking on – now that the Bust has arrived.

This would have been much better undertaken at the first signs of trouble, over four years ago, than now and – given the difficulties of achieving a fair, judicial burden sharing when PUBLIC sector borrowers become involved – it would have been much better without the intervening folly of crude Keynesian stimulus, pace Soros, Krugman, Wolf, et al.

Greece should cut its debt to the maximum level consistent with its long-term sustainability under the constraints imposed by its currently poor growth prospects and it should be made to run a balanced budget henceforth – perhaps through denying it any new credit on terms which are too soft. If that means the state must shrink and people can only receive what they themselves can earn and pay for, so be it. I am confident that this would open up untold avenues for private wealth generation. After all, the Greeks have been noted traders and entrepreneurs since history began – while their current societal degeneracy has been an artefact of state intervention – whether their own or the preceding Ottomans’ – and it is high time their natural talents were given free reign, rather than their natural human proclivity to do as little as possible when someone else seems to be paying for whatever it is that they most require.

That this transition is unlikely to be a pleasant experience is not to be denied, but neither is the present prospect of hopeless, semi-permanent “austerity” – besides which, their great-grandfathers went through much the same experience in the late 19th century and came out much the better for it!

As for Western banks and insurers – well-tough! Caveat commodator – let the lender beware! Their own creditors and shareholders should be the first to take losses for their voluntary participation in such bad executive decision making, as they would in any other business. If that takes them to the brink of failure, again, so be it: let the strong buy out the weak and let’s reduce the count of those making a living by leveraging off both explicit and implicit taxpayer support in a ludicrously overbanked world.

Any role for government should be limited to expediting the transfer of titles from debtor to creditor, as well as the transformation of title from debt to equity with a final, backstop role in guaranteeing a minimum level of narrow money circulation so as to avoid a self-fuelling secondary depression.

What kind of a solution do you think that the EU/IMF will arrive at for Europe’s debt crisis?

Sean: I doubt it will be anything as comprehensive as the above, though, given recent developments, if the Northern members stand firm and we listen to those Bundesbankers who are trying to insist upon individual fiscal responsibility – as well as to restore a renewed, future separation of fiscal from monetary policy – rather than to the cabal at the ECB which seems to think its job is to protect bankers, not the value of the Union’s money, then we might be a lot closer to this than was conceivable even six months ago.

Do you think that the ECB will resort to large doses of QE in order to ease the pressure on the eurozone?

Sean: At the moment, I would only see this happening by default. That is, if they have to offer so much support to shore up the existing debt structure that it becomes operationally difficult to sterilise.

There is a touch of the Oscar Wildes about the fact that they have already lost two Bundesbankers in swift succession. I’m not sure they would risk the implicit rejection of their policy entrained in the resignation of a third.

Do you expect to see countries leaving the eurozone?

Sean: Strictly speaking it is unnecessary if the undoubtedly steep adjustments needed are taken by reducing prices, removing costs, and eradicating impediments and inefficiencies. Our Keynesian friends, with their unshakable thirst for monetary chicanery, sneer that such an “internal” devaluation; is impossible, but it is more honest, more equitable, and more salutary than the alternative of a mass resort to the money illusion of a currency devaluation.

Anyone who doubts this should look at the fact that, though not entirely without blemishes and short-cuts, one or two eastern European nations – as well as the Irish –have already gone a very long way down this road.

That the positive results for the first have not yet made themselves so clearly felt in the Emerald Isle is almost entirely due to the fact that Ireland was shamefully bullied by both the ECB and the US Treasury into the untenable co-option of the privately-contracted debts of its banking sector at the height of the crisis. Ireland should also put these straight back where they belong – with those banks shareholders and creditors – and should instead concentrate on making sure that all their hard-work in rebalancing the economy redounds to the well-being of the ordinary Irishman and woman.

So, to come back to the question, to see a secession, much less an expulsion, we have to assume that the distaste for the Greek’s –and others’ – persistent free riding (as expressed recently by the likes of Otmar Issing) overcomes fears that this will weaken, not strengthen, the remaining union by setting a dramatic precedent and so focusing market scrutiny even more closely on the finances and political temperament of those left in the club. We also have to assume that the leaver’s elites see the subsequent trauma as either lesser in nature or easier to blame on others.

Until those two conditions are filled, I would expect the Nomenklatura to continue to inch painfully towards a solution which entails no shrinkage of the Union, entailing, as this would, the relinquishing of 80-odd years of political wishfulness.

What sort of things are you looking at to discern whether or not gold is overvalued or undervalued?

Sean: What is “value” in a world where the single goal of the powers-that-be is to deny the market the ability to have its constituents’ underlying ordering of wants accurately reflected in the price structure?

We have no proper market in capital; severely impaired markets in any number of basic goods; false markets in real estate; distorted markets in labour (hence why so many poor souls are still without jobs) and no certainty about anything except the awful certainty that nothing is off limits to those who are desperately trying to put Humpty Dumpty together again in time for the next turn of the electoral cycle rather than accepting the fact that he’s shuffled off this mortal coil and that it would be better now to see whether at least we can salvage a half-decent omelette out of the remains?

Gold is moving up as central bank balance sheets expand at an inordinate pace and as trust in fiat currencies erodes accordingly. Gold is working also as a diversifier – even an insurance policy – in a portfolio of real assets: outperforming other commodities and equities when we are in one of the recurring “Risk Off” phases which are so stultifying recovery.

Occasionally – as, for example, in late summer – it gets palpably overbought by those who are attempting to use zero-cost finance to game all this confusion and, as a result, it often suffers violent corrections.

However, while the perception persists that inflationism is the first line of defence, and while no one can be sure that – thanks to the stupidity of the Fed and its peers in trying to deny the reality of the losses we suffered under their previous regime of over-easy money – further financial disasters do not lie just around the next bend, it is hard to say that gold will not continue to do what it has for much of the past 5-6 years and grind ever higher, especially in USD trade-weighted terms.

Do you expect to see Britain facing the kinds of problems that are currently affecting the PIIGS?

Sean: Well, when the Crisis first broke, I used to joke that we Brits should not be too supercilious about the PIIGS since we had Scotland, Wales, Ireland (North), and England – aka, the SWINE!

The UK’s “austerity” package is so far somewhat elusive to locate since spending is still creeping up. The country still runs a near record trade deficit in the middle of a slump, despite having a currency whose decline in the Crash was only beaten by that of the Icelandic Krona.

Since 1998, Britain has lost 40% of its manufacturing jobs and added 35% to its roster of public sector workers, increasing the ratio between these two classes of tax-payers and tax-eaters from 60 drones per 100 bees to 160! And now, despite the highest level of joblessness since 1994, we have the highest gain in the Retail Price Index in 20 years, with the Bank of England actually easing as it rises!

Given the fragile coalition which is in office and the size of the lobby for maintaining public spending – as well as the almost insurmountable, pro-Labour electoral calculus built into the geography of the constituency boundaries – it is hard to see how the deficit, much less the debt will be meaningfully reduced without an eventual recourse to the tried and trusted old methods of inflation.

What’s your opinion of ‘Europe v. America’ in terms of economic health?

Sean: Well, for now, Europe seems to be reluctantly facing up to the reality that the state treasury is not a bottomless barrel and that public sector cannot live up to its casting as the Keynesian Tooth Fairy. This may not stand the test of time, but, for now, there is something of a push to reining in budgets, not expanding them endlessly.

We can hardly say that about the US where almost 40% of the enormous $1.3 trillion deficit is unmatched by revenues of any kind – something that Professor Bernholz at Basle University has identified as a threshold beyond which the threat of accelerating inflation becomes very real.

On the one hand, the Democrats seem to think that taxing the odd millionaire a few extra dollars will solve all the nation’s problems, and, on the other, the mainstream media won’t even accord any airtime to the one man to have foreseen the difficulty, to have consistently analysed the cause, and to have put forward radical, but logical proposals for dealing with the issue – namely, Ron Paul. In each case we are hollowing out the middle classes and reinforcing the divide between the plutocracy and the pauperised. In each case enterprise is being stifled and the flames of a paralysing uncertainty are being stoked ever higher.

America is traditionally seen as a more “flexible” society where the barriers to entrepreneurship are fewer and hence where recovery is both swifter and more assured, but, the laziness of relying on the ever-open chequebook of a woefully compliant central bank could do an awful lot to undermine whatever marginal advantage the nation still possesses over Welfare State Europe.

How dependent on western demand is the Chinese economy? Is “decoupling” a flawed concept?

Sean Corrigan: This is harder to say in absolute terms than many will admit, but, undoubtedly, the economy stands on two main pillars, neither of which is as steady as it might be.

Externally, the West still supplies much of its market and, in terms of its overall trade surplus, the US alone has accounted for more than 100% of the past two years’ total, and for 75% of the past five years’.

Even if we can argue forever about what the ultimate value added component of all this is, China’s exports amount to around a quarter of its published (if highly dubious) reckoning of GDP, so, clearly, a significant numberof livelihoods are dependent both on this and on the import and shipping of those goods that give rise to such exports.

However, such is China’s wayward economic structure that it has distorted all manner of pricing signals internally, too – the cost of capital, of land, of energy and other inputs – so that the second, shaky pillar on which it relies takes the form of ever more, credit-fuelled, higher-order malinvestment to generate its famous 9%+ national income scores.

It is only a little tongue in cheek to say that when we consider that the nation has yielded up a good deal of its comparative advantage (however illusory some of this was) and unleashed a nasty inflation – complete with a boom in what will prove to be either marginally productive, or completely unproductive, property and infrastructure – that it has sucked up into underremunerative ends its people’s savings, even as it purports to offer them a job not otherwise to be had in building more of the same, there are parallels with the mid-90s Asian Tigers.

Back then, their increasing uncompetitiveness and their growing misuse of resources on turning cheap money into expensive real estate was a key signal of the bust to come. The main difference with today’s China is that far less of this present excess is being financed with hot foreign money, given the difficulties in – though not the impossibility of – transferring funds across the current account barrier.

China is indisputably an enormous accident waiting to happen, but the only thing which may prove uncomfortable for the China bears among us is the nation’s unquantifiable, but redoubtable ability to hide the true cost of all this and to shuffle money endlessly from one balance sheet to another – to hide subsidies and support payments in a welter of accounting confusion and soft loan extension. Even the Soviets had their moment in the sun, remember, when Khrushchev’s tentative economic reforms in the 1950s seemed to offer a better way of doing things than either his predecessor or his contemporaneous Western competitors could manage.

When Adam Smith remarked, two centuries before that, that there was “a lot of ruin in a nation”, he was giving cold comfort to those long CDS protection or short Ozzie banks!

American financial analyst Jim Rickards has cited four potential outcomes to the world’s current monetary problems: multiple reserve currencies; SDRs; gold; or chaos. Which of these do you see as the most likely outcome – or is there another possibility?

Sean: Barely-managed chaos is what we have endured for the past 40 years – and arguably for much of the 60 years before that. I’m not sure that does not remain the smart way to bet, whatever the ambitions of the One World Platonic elite for a global Federalist construct to be forged in the funeral pyre of finance corporatism!

What things can ordinary people do to protect themselves from the economic fallout that may result from all these events?

Sean: The goal of the authorities is to make every man a gambler or a wastrel, for that way, it is assumed, the stock markets will rise again and cash registers across the land will ring out a merry peal of renewed Keynesian prosperity.

The sad truth, of course, is that this is a road to ruin along which we are all being force marched by the inflationist intellectuals and the other indefatigable defenders of the Provider State which their policies underwrite.

Hence, we can only offer generalities. Work hard; work longer; pay down all unproductive debt – at least until such time as you are sure that the interest burden and redemption schedule you face will be washed away by the loss of value of the money in which the loan is denominated. Try to acquire as much flexibility as possible in your finances for everything is – and is likely to remain – in a state of flux for a long while to come, with few certainties attached to the path by which we will eventually be forced to recognise the degree of our self-impoverishment. Try to find honest and competent entrepreneurs in whom to invest as these provide the best ‘active management’ of your money of anyone, especially when times are hard. Try to turn soft money into hard value wherever you can identify it.

This is all every well to say, of course, but much, much harder to achieve and meanwhile, there is the awful truth that there is no reward for thrift, no safe haven for one’s savings, and that the greater one’s success in managing one’s affairs and the greater one’s moderation in spending the rewards of that success, the larger and juicier the temptation one offers for an increasingly rapacious tax man to siphon off one’s reserve into the echoing depths of the state’s empty coffers.

Sadly, there can be few guaranteed winners in such a world.

“Gold – a six thousand year-old bubble”
- Headline of an FT piece from 2009 by Willem Buiter.

There are still reasons to like Mel Brooks, and most of them are in “Blazing Saddles”. As with the output of other writers and directors, it’s always the early, funny ones that last. Brooks’s 1974 Western spoof happens to give us the perfect embodiment of the witless bundled morass of hugely conflicted high absurdity and outright surrealism that constitutes today’s financial markets and the major players within them (sovereigns as well as banking institutions). Take the sequence where new sheriff and gentleman of colour Bart is attacked by a raging mob. To divert them, he holds a gun to his own neck. Of course, in the face of such dramatic posturing, the townspeople have no choice but to back down. Hold it, men. He’s not bluffing.

For Bart, read any number of financial institutions that have managed – bizarrely – to escape the clutches of the fate they otherwise deserve by threatening self-immolation, and have gone on to extort billions from baffled taxpayers and overly supine (or biddable) politicians. Suffice to say, financial markets have been living for some time in a Looking Glass world where logic, rationality and common sense no longer hold sway. What we get instead, as we wait not so breathlessly for the latest announcement of a plan to make a plan from the euro zone’s political “leadership”, is equivocation, prevarication and obfuscation. What will surely come, for many, is wealth obliteration.

But, as Jeffrey Gundlach stated recently, we are not policy makers, we are stewards of other people’s capital and we are here to outperform. There may be constructive changes to the financial infrastructure that we think would best serve the most number – we would advocate reform of fractional reserve banking that would prohibit essentially fraudulent lending, and abolish entities such as the Federal Reserve whose primary service is dedicated to sustaining an unsustainable narrow banking elite even as the rest of the economy burns – but our immediate focus is navigating the treacherous waters that those same entities have so dangerously perturbed. So we are where we are, even though we would prefer not to be starting from here.

The problems are well known. Our base thesis is that a credit bubble of some forty years inflating has now gone objectively into reverse. The western economies, by and large, will simply be unable to grow vigorously enough even to service their accumulated debts. Different countries and cultures will resort to different strategies to try and muddle through. For some (i.e. Greece) that will probably mean default. A disorderly default could easily result in financially painful contagion rippling across to the core. For others (e.g. the UK), the authorities will resort to, or indeed have already resorted to, inflation. Or financial repression, if you prefer. The ultimate outcomes will be a product of politics as much as economics, which makes them difficult if not impossible to predict with any degree of certainty. There are obvious implications here for currencies, particularly those of the more conspicuous money-printing countries. Whether in terms of debt repudiation, asset deflation, financial system imperilment or monetary inflation, we think all roads lead to gold. Which makes the scale of the recent sell-off of gold in nominal dollar terms curious, but does not cause us anything beyond minor mark-to-market indigestion. A minor burp, if you will, for an otherwise contented baby.

The now seemingly constant and elevated financial market volatility does give rise to second order concerns, though. These are concerns that the human brain is not evolutionarily well equipped to handle. Nicholas Carr’s “The Shallows” asks what the Internet is doing to our brains. John Horgan, reviewing the book for the Wall Street Journal, wrote that

We all joke about how the Internet is turning us, and especially our kids, into fast-twitch airheads incapable of profound cogitation. It’s no joke, Mr Carr insists, and he has me pursuaded.

In Michael Lewis’s latest, “Boomerang – the meltdown tour” (reprints of some excellent Vanity Fair articles on the financial crisis) he cites Dr. Peter Whybrow, a neuroscientist at UCLA who “thinks the dysfunction in America’s society is a by-product of America’s success”. The argument runs as follows. The human brain evolved over hundreds of thousands of years in an environment “defined by scarcity. It was not designed, at least originally, for an environment of extreme abundance.” Dr Whybrow describes the human brain as “fabulously limited”. We may possess a mammalian and third layer of brain matter, but they both surround a reptilian, lizard-like core. Our passions, suggests Dr Whybrow, are driven by the lizard core:

The succession of financial bubbles, and the amassing of personal and private debt, Whybrow views as simply an expression of the lizard-brained way of life. A colour-coded map of American personal indebtedness could be laid on top of the Centres for Disease Control’s colour-coded map that illustrates the fantastic rise in rates of obesity across the United States since 1985 without disturbing the general pattern. The boom in trading activity in individual stock portfolios; the spread of legalized gambling; the rise of drug and alcohol addiction – it is all of a piece. Everywhere you turn you see Americans sacrifice their long-term interests for short-term rewards.

Anybody tasked with staring at a Bloomberg terminal on a regular basis inevitably turns their thoughts to the motives of all those unseen investors silently driving markets higher or lower, on a daily basis. Our lizard brains, one suspects, are not well-suited to watching investment markets soar or collapse with exactly clinical detachment. “Fight or flight” does not translate well, or necessarily profitably, to volatile markets in one’s pet investment themes. But our hypothetical Bloomberg-watcher, if not ourself, also labours under the fair presumption that there are unseen humans at the other end of those trades. What if they’re actually robots ? One of the few, and perhaps only, intelligent insights that John Maynard Keynes made was his comparison of financial market participants with judges in a beauty contest:

It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.

Or in other words, investors tend to spend a good deal of time trying to anticipate the market reactions of other investors – as opposed, say, simply to uncovering objective deep value and sticking with it. So what happens if our putative beauty contest / financial market judges are actually machines ? Some sources indicate that high frequency and algorithmic trading (for want of a better short-hand: a bunch of robots) now accounts for three quarters of all US equity trading volume. So our hypothetical Bloomberg-watcher is now trying to assess the extent of greed and / or fear at work in a market that may be devoid of much direct emotional response and is now the plaything of a dispassionate trading algorithm or two. Good luck in trying to understand what R2D2 thinks about the latest unemployment figures.

The human brain has evolved to a high art of pattern recognition. The exquisite irony of our time is that we may be looking for patterns in markets where none really exist – just the vapour trail of C3PO’s latest software instructions.

One of the pieces we are most frequently asked to republish is the fictional creation of Nassim Nicholas Taleb in “Fooled by Randomness”, namely his retired dentist. This hypothetical investor is guaranteed to earn 15% per annum from his portfolio with an associated volatility in returns of 10%. These statistics are not open to dispute. But if our dentist monitors his portfolio in real time, the random price oscillations of his portfolio are likely to trigger extreme anxiety (and to most people, a natural if sub-optimal desire to overtrade, to take profits or cut losses). Depending on the frequency with which he observes his portfolio, our dentist will experience varying degrees of heartache or distress. The frequency of portfolio observation versus the probability of a profitable and therefore pleasurable outcome for Taleb’s imaginary investor is shown below:

The message, we trust, is clear. Too much observation can, plainly and simply, be bad for you – because it will tempt you to overtrade, and to sell fundamentally sound investments in the interests of loss aversion. If Taleb’s dentist simply restricts the frequency with which he checks his portfolio – a fundamentally sound portfolio – he will boost his chances of incurring a positive emotional outcome from his monitoring activity. Note that nothing here changes about the composition of his portfolio – only the frequency with which he checks it. Investors determined to sit and watch the pot may end up being scalded. For that matter, Keynes came up with another intelligent coinage: markets can remain irrational for longer than you or I can remain solvent. Amen to that. So we sit here, with a diversified portfolio incorporating gold, silver, gold- and silver-related mining stocks, high quality debt, a modest allocation to defensive equities, and some systematic trend-following funds, and a tad of cash, and we wait. Like Odysseus’s sailors we feel inclined to stuff our ears with wax rather than succumb to the latest asinine market-as-sports commentary from CNBC, or for that matter to turn off the Bloomberg terminal for a bit. But in any event we retain high conviction about our core investment themes, and short-term market volatility, 24/7 investment jabber, and even the trading activity of robots will not divert us from our course. Beyond that, only time, and the great weighing machine of the markets, will tell.

This article was previously published at The Price of Everything.

Previously published at ZeroHedge …

1. Q1 EFSF.

We here at ZeroHedge have labelled the EFSF as an off balance sheet CDO, whose purpose is to buy the toxic assets (in this case sovereign bonds) of the ECB and the EU, all under the safety of a AAA rating. The amended EFSF of July 21, 2011 will aim at having a lending capacity of €440B. With rumors about bank recapitalization and monoline type guarantees that will leverage the fund to €2T. The EU/ECB has been committed to “avoiding contagion” since the Greece issue started 2 years ago, and as of October 2011 we are now talking about France losing its AAA rating. Do you believe that this expansion of the EFSF both in Euro terms and the mandate of the fund, will be enough to contain the debt contagion worries? Or is it actually necessary for what is currently implicit, that Germany is the de facto leader of Europe for the third time in 100 years, to become explicit?

Answer: The best answer to worries about ‘debt contagion’ is to make clear to all the counterparties concerned just what exactly is on whose balance sheet and at what price and to stop playing accounting tricks in order to paper over the holes created by all the bad lending practices indulged in during the Boom – missteps since repeated in some cases in the attempt to game the Eurozone’s initial bail-out procedures in its aftermath!

It is also a little ironic that the entities most likely to spread any such ‘contagion’ are largely the same ones who are hoping that they can get a huge slug of Other People’s Money – without too many onerous conditions attached – poured in to prevent said contagion from impacting their bonus pools too adversely– namely the trading desks of the selfsame European banks!

As for the EFSF/ESM, insofar as we even need a ‘rescue fund’ at all, why do we need anything more than a temporary bridging mechanism – a kind of cash-rich clearing house where failing businesses – banks above all! – can transfer their assets to the thriving ones as rapidly as possible and where debt to equity conversions can be undertaken (not least by overstretched state borrowers) at a price consistent with their continued employment in an independent, self-reliant, going concern?

Will we get any of this detached minimalism in practice? Highly unlikely, of course, for our fat political turkeys will not willingly vote for a Poujadist Christmas! So we are left with trying all the idiot savant ways we can transfer from the playbooks of AIG, Enron and Lehman (and maybe Madoff!) to preserve the status quo ante.

What we have to hope is that the very fact that the debate has become so contentiously aired outside the smoke-filled rooms of Brussels; that national Parliaments are refusing to be presented with yet another executive fait accompli; and that respected figures like Otmar Issing are warning against the seduction of financial ‘alchemy’ while making overt references to their conduciveness to a rerun of Weimar, might be enough to see that the Beast is sufficiently starved that it does not allow the adoption of genuine solutions to the problem to be deferred any longer.

As we know, the aim of the game to this point has been only to do the self-evidently right thing after every last, Collectivist. reality-denial alternative has been exhausted – but it might just be that the Franco-German schism sets us up for just such an outcome.  Daumen drücken, as they say, across the Rhine!

2. EU Bank Recapitalizations

As part of the recognition that there will be a “liability management exercise” in Greece, perhaps with haircuts exceeding 50%, attention has turned to the under-capitalized EU banks. The numbers about how much capital these banks need range from €100B to €1T. The question is where does that capital come from? Is it possible or banks to raise that capital without a)nationalization & b) losses for senior bondholder? Is this issue of capital and where it comes from even relevant if the banks are going to be given a year (as is rumored) to raise the capital?

Answer: Well, in the first place, if we realize that European banks are trading on price/book ratios of as little as 30%, we can see that the farce of pretending the balance sheet is sounder than it actually is has already been repudiated by the market itself, so why not take the hit and restore faith in the company and the integrity of its management?

Secondly, if we note that some 30% of European bank assets take the form of loans to, or securities holdings in, other – mainly European – banks, we can see that some grand, mutual ‘tear-up’ of all this I’ll-lend-you-if–you-lend-me, economically otiose duplication would immediately free up a sizeable chunk of capital without actually having to go to market and beg for it.

Incidentally, the Victorians used to scorn the practice of such financial incest as ‘pig on pork’ and regarded it as beyond the remit of a proper banker. It might not hurt if we started to do likewise.

Thirdly, why are capital-poor banks still paying dividends? Why is executive compensation in what are effectively failing enterprises still so elevated? The most reliable source of capital to a business has to be that portion of the difference between income and outgo its retains within the business (though it might also help if central banks were not doing their best to eradicate net interest margin at the same time!). Why is that principle so difficult to apply to the banking industry?

Moreover, there are currently more the 7,700 ‘monetary financial institutions’ in the Eurozone, with another 2,000-odd in the rest of the EU. In a world of teraflop data management, ubiquitous smartphones and always-on internet connection, do we really need one bank for every 50,000 people? Consolidate, consolidate, consolidate – and then we’ll see if there’s enough capital to go around!

Finally, as for the question of whether senior bondholders should be involved, what other, more effective mode of instilling a semblance of discipline and self-restraint into the system could we wish for? Caveat commendator – let the lender beware!

3. Three years later

We celebrated the 3rd anniversary of Lehman brothers bankruptcy just over a month ago. Yet three years later, we are again talking about a TARP program for Europe. Again we are subverting the interests of the majority to keep the Banks (not the financial system but the Banks that make up that system) alive. The status quo elites, all take for granted that a TARP like program is the only solution. That Lehman 2.0 cannot happen. We wonder if there is not another way. Is there a way to shore up the EU financial system that does not include recourse to either the ECB or a TARP program?

Answer: If we had done some of the above from the off, the original recession may well have been deeper, but it would also have long since ended and now – actually more than four years, not three – since the first cracks appeared, we could have been well along the path of genuine recovery and not struggling along the money-illusion travesty of one we have since been following.

But, no – we had to apply the mindless, Keynesian pass-the-parcel approach instead, under the rules of which when A (quintessentially a house buyer, this time around) suddenly finds he can no longer borrow money to buy more than he can actually afford, then B (usually the state) must step in and take his place as a spendthrift lest C has to find another customer for whatever it is he has grown over reliant on peddling to A and also so that Bank D, whose bosses have paid themselves handsomely for financing all these errors, can avoid having to bear the consequences of their poor decision making.

In the case of the public sector, this should be a time to write off whatever debt cannot conceivably be repaid with the proviso that all the member states – not just the defaulting ones – will guarantee not to add a single cent to their remaining stock of obligations but that they will balance their budgets henceforth.

This will not mean the defaulters will get off scot-free – they will still have to live within their means without resort to the kind of profligacy to which they have become accustomed, but at least they will be unshackled. Moreover, it have the added bonus of teaching everyone else (including regulators!) the historically unavoidable lesson that sovereign debt is anything but risk free, so reigning in the state’s ability to subvert its duty of accountability, everywhere.

Preferentially, this new budgetary rectitude should be brought about, not by raising taxes, but by shrinking the greatly overexpanded scope of the state’s activities – by privatising assets, reducing the deadweight of the various bureaucratic agencies, and by drastically pruning all debilitating and demoralising interventions to a bare minimum of social provision.

That way, we would immediately free up the maximum possible opportunity for private sector wealth creation to expand into the gap we leave and it would simultaneously impose the least costs on both the entrepreneurs who must be encouraged to lead this regeneration and on the workers and savers on whose efforts and funds they will rely on to carry out their ideas.

This would not only ensure that the inevitable drop in people’s real incomes will be minimised in the here and now – a shortfall which has arisen because of what we did in the Boom, not the Bust, remember – but it would offer the best prospect of rebuilding them as rapidly as can possibly be envisaged.

Think of it as a Berlin Wall moment for the whole of Europe as the deadweight of inflationary Welfare State Corporatism was removed from – or at least lightened upon – the backs of 400 million people.

4. The Euro

This is a simple question of whether or not you see the Euro as a common currency of 17 different countries surviving the next decade? Can you envision a scenario whereby a country leaves the Euro, yet the Euro doesn’t collapse as a result?

Answer: Contrary to popular belief, there is no need for a fiscal transfer union, much less an overarching political supersovereignty, to guarantee the viability of a currency union. Mankind managed pretty well from the time of Croesus’ first Lydian coins to the beginning of the Great War by swapping shiny bits of gold and silver – not to mention cowries and other such exotica – for goods and services where there was not an immediate coincidence of wants between buyer and seller.

Money is a medium of exchange, that’s all, so why can it not ‘survive’ by the mutual consent of its users across, as well as within, those artificial barriers we call borders without eradicating all cultural, legal, and institutional differences between the peoples contained within them?

Of course, if that consent is withdrawn, that is another issue. If, for instance the northern Europeans feel that they only want to exchange monies freely among themselves or if their erstwhile southern co-unionists suppose that they will confer some tangible competitive advantage upon themselves by leaving (presumably with a view to treating themselves to the highly elusive benefits of a currency devaluation), the boundaries around the existing membership might change – and even become so small as to be practically purposeless and so expire.

I do think, however, that if there’s one thing which, at the moment, passes for a minimal level of consensus among a heavy majority of European decision makers, it is that the benefits of a single currency outweigh its drawbacks – though whether that warm glow of confraternity would survive the very transfer mechanisms which many see as its saviour is, to me, very much a moot point, since it would further identify the currency with the resentment of those who consider themselves diligent at having to subsidise those they see as indolent.

5. Goldman and Targeted GDP

In the last day Goldman’s Jan Hatzius has suggested that “Fed officials to ease policy significantly further would be to target a nominal GDP path…indicating that they will use additional asset purchases to help bring actual nominal GDP back to trend overtime.” This justification for additional QE is that it will assist the “full employment” part of the Federal Reserves mandate. We would like to hear you comments on a) whether targeting a nominal GDP level is possible? and b) will such targeting actually benefit employment in the USA?

Answer: The instinctive reaction when an institution like that comes up with a wizard wheeze to solve the world’s ills is to reach instantly for one’s pocketbook!

Facetiousness aside, as a card-carrying Austrian of long-standing, the emergence of this whole subject as some kind of startling breakthrough actually makes me smile since the basic idea was long since foreshadowed by Hayek and is actively promoted today by the fractional reserve, free-bankers (FRFBers) among the School.

Go and read the works of George Selgin, Larry White, or Steve Horwitz (e.g., at freebanking.org and coordinationproblem.org) for further elucidation, or consult cobdencentre.org to get a flavour of the arguments advanced against it by 100%-reservers like me.

What we must be clear on here, though, is that the suggestions of Hatzius and his ilk are all very much at one with the prevailing top-down planner, central bank-lever pulling mode and so are very much subject to Fatal Conceit/Knowledge Problem objections. In addition, they all seem to think their should be a ‘target’ – i.e., some divinely-ordained number, plucked out of the entrails of some DGSE ritual calculation; one which, of course, must be a bigger number than the one we have today and, worse, one which must be driven to increase at an arbitrarily determined rate thereafter.

This is a VERY different kettle of fish to what even the FRFBers propose which is simply that Free Banks – that is, those institutions which issue private money on the strength of their own competence and reserve base, absent all support from the state (whether explicit or implicit) and bereft of all legal favouritism before the courts – should be allowed to issue extra monetary claims on themselves whenever it becomes apparent to them that the holding of such is the overwhelming preference of their customers.

Another crucial point of difference is that the converse must also apply – i.e., that the Free Banks will pro-actively retire such claims when it later emerges that their customers’ tastes have changed.

This, the FRFBers argue, is what their system will in fact ensure in a wholly automatic fashion so that, if there is any sudden rush to hold more money for its own sake (loosely, if there is a downward change in that money’s ‘velocity of circulation’), this will not exert any destabilising influence upon the real economy at large.

Furthermore, the FRFBers point out that an unsupported Free Bank is one which is subject to a reputational competition with its peers, as well as to the more concrete constraint of the need to reach a balance with them during their mutual clearings. These attributes, they contend – coupled to the insurance company-like liquidity threat which exists to its privately-subscribed equity capital should it ever misread the intentions, or forfeit the trust of its customers – will similarly prevent destabilisation through that Bank’s undue expansion, either (for reference, it should be noted that we 100%-ers are more than a little sceptical about this particular assertion).

We must re-emphasize, however, that the point here is not to set omnipotent, Stalinist directives for what Nominal GDP ‘should’ be, much less to decree to what path its future trajectory should conform, but rather to allow the bottom-up, negative feedback of an emergent, systemic property to operate to maintain an even flux of money through the economy at all times, so as to make it as neutral an agent as possible in everyday business calculation.

Furthermore, where the FRFBers and we 100% reservist Austrians do agree – in marked contrast to the mainstream – is that money should NEVER be created merely to stop prices falling. On the contrary, we firmly believe that all productivity-led price declines – as opposed to those which are the results of an active monetary deflation (the perceptive reader might spot that we 100%ers are less fearful of any passive, quasi-deflation which arises through greater money hoarding)– are not only a benign, but, in fact, a necessary quality of a properly-functioning price mechanism, one whose suppression by today’s central banks is a highly disruptive element, very much conducive to the kind of wasteful boom and bust we have just endured.

So, to sum up: there are some highly-regarded precedents for (if also some heart-felt objections to) the idea of looking to some broad measure such as nominal GDP as an anchor, but be aware that those who are arguing for it today are not really suggesting any radically better way of conducting policy, but simply seeking to rebottle their vinegary old plonk of chronic inflationism and Vampire Economy Führerprinzip under a shiny new label.

6. Macroeconomics vs. Microeconomics

You have repeatedly said that:

We must recognize that there are no workable macroeconomic solutions which can be laid down: that everything is a matter of functioning microeconomics building things up….

With governments and monetary policy authorities in the developed world continuing their love affair with macroeconomics, with models, pushing on levers, and central planning, more often that with disastrous consequences, can you actually imagine a circumstance whereby that same group start to embrace microeconomics solutions? That those with the most entrenched power, acting in their OWN best interest, will forgo the former and the latter, to actually effect change?

Answer: I refer my learned friend to what the estimable Ron Paul wrote in the WSJ recently, viz:-

“What exactly the Fed will do is anyone’s guess, and it is no surprise that markets continue to founder as anticipation mounts. If the Fed would stop intervening and distorting the market, and would allow the functioning of a truly free market that deals with profit and loss, our economy could recover. The continued existence of an organization that can create trillions of dollars out of thin air to purchase financial assets and prop up a fundamentally insolvent banking system is a black mark on an economy that professes to be free.”

So, to answer your question: if Ron Paul gets the Republican nomination, much less wins the subsequent election, you know there is still hope but, since the mainstream media can barely bring themselves to mention the man’s name, I wouldn’t bet the farm on it, just yet!

7. The Federal Reserve: Should it exist?

In January of 2008 your wrote:

From their very first incarnations in 17th century Sweden and England, central banks have been purposeful mechanisms for shoring up profligate governments (whether these are buying guns or butter without properly funding the purchase) while serving as a backstop to the inherently flawed and highly unstable practice of fractional reserve banking”

Our question is simple, theoretical, and something that ZeroHedge readers think about often, Should the Federal Reserve (as conceptualized in the USA) be abolished? If so what do you replace it with?

Answer: Do you really need to ask??? I would abolish it as soon as can be arranged.

One possible mechanism to achieve this has been thrashed out by several of us at the Cobden Centre in the context of ridding the UK of that destructive 318-year old canker of monopoly and privilege which is Bank of England. For what it’s worth, my version of this was presented to an audience at the IEA in July of last year, the barebones of which are appended below.

As to what we should replace it with – why nothing of course! Just free banks, free to fail and free to flourish – just as there are free florists, free furniture makers, and free fashion houses – nothing more and nothing less.

8. OWS Movement, Arab Spring, Greek & UK Riots ……Collateral Damage

What started in January in 2011 in Tunisia, has In October of 2011, moved to the USA. The one constant thread in all of these movements is the profound lack of fairness in society and the profound lack of confidence in governments and the institutions  they represent.

How do you view the OWS movement? Does the movement cause you any concern?

Answer: To the extent that it provides a focus for left-wing disgust at the plutocracy, much as the Tea Party provides one for those who are considered as right wing, that is all to the good. My enemy’s enemy is my friend, after all.

However, the problem is that many of the protestors see this as a failure of something they have heard fat-cat beneficiaries of the system, like Michael Moore and his kind, decry as ‘capitalism’ and so they are under the grave misapprehension that what is needed is a more activist government to take the reins, blissfully unaware that today’s Corporate Welfarism is more like something Mussolini – or his self-confessed admirer, FDR – would recognise as an alternative to, rather than an embodiment of, ‘capitalism’.

What they miss is that to be pro-market, is not to be pro-bank, much less pro-business since businessmen – especially Big Businessmen and ESOP guns-for-hire and Military-Industrial, US Treasury-Wall St. revolving door merchants, as opposed to real owner-entrepreneurs – are often just as inimical to the workings of the free market as any trade union militant or pink-tinged academic tritely disporting a Che T-shirt.

It is actually quite heartening to see that ordinary people are fed up with the pseudo-choice they are offered at the ballot box by two giant, entrenched, self-serving party machines which have far greater commonalities than differences. I think you see the same thing with the likes of the Pirate Party in Germany, the Real Finns, and Christoph Blocher’s Swiss SVP.

The worry, of course, is that these same people, through no fault of their own, have not been given the tools with which to analyse their plight properly, nor have they been educated in a rich enough vocabulary in which to properly articulate their dissent and so there is a distinct possibility that they become co-opted either by some fiery demagogue or, as in much of Europe, by the dangerously illiberal Khmer Verts who camouflage their despotism in the cuddly panda pyjamas of the Green movement.

On a more hopeful note, these protests show that the Establishment – and a post-1968 Establishment, no less – has lost both its power of command and its automatic right to respect and that can only give us in the libertarian Remnant greater opportunities to fill the void, too.

9. Of Being 25 in a Developed Nation

We here at Zero Hedge are labelled as fringe lunatics who thrive on bad news. We only take issue with this to the extent that the label allows “others” to dismiss us out of hand, while not debating us on the merits of our ideas and opinions. Central to our platform is the debunking of generally accepted conclusions of mainstream Wall Street Economist and Strategists. We do so, not only because it is sometimes fun, but because we want to encourage our readers and ourselves to think beyond what we are all being spoon fed. We are interested in what advice you would give a 25 year old graduating from University about the future. How should they think about money, how should they be investing, and what do you think their future will look like (10 year time horizon) in a developed nation? Would you give different advice to a 25 year old in an emerging nation?

Answer: The first thing I would say is that, from direct personal experience, he should not even begin to imagine that he has completed his education , just because he has been awarded his degree!

If he (I’m sufficiently advanced enough beyond the age of 25 to luxuriate in the presumption that ‘he’ is a non-gender specific pronoun in this context) is lucky enough, his university will not just have shepherded him though a few exams, but will have encouraged him to learn how to think for himself and to trust his judgement when he applies that ability rigorously enough.

If he has been astute enough, he will also have realised that he needs to be equipped with a few basic tools beyond his specific expertise in order to navigate his way through the sea of half-truths and lazy presuppositions which are likely to surround him.

Firstly, he needs basic numeracy skills so he can have a sense of magnitudes, costs, and probabilities. Secondly, he needs a sense of geography so he knows where he is and a sense of history so he knows when and who he is. Thirdly, he needs to be able to both understand an argument and to make one, so that he can spot the falsehoods he is constantly being sold (sometimes, it has to be said, wholly inadvertently) and so that he can make his own case in response, once he has framed it. Finally, he needs to realise that the state is a wolf, not a sheepdog and that his liberty and right to self-expression are much more at risk from the smiling, ballet-box tyrants at home than it ever is from the foaming-mouthed, comic opera dictators whom he is enjoined to hate abroad.

He should realise that money is a medium by which wealth is exchanged, it is not wealth itself, much like it is the information he trades over the web which is important, not the plumbing of routers and servers and cabling which transmits it.

He should also be aware that when it comes to matters of money and economics, most of the ostensibly-learned discussants are sadly espousing ideas no more advanced or well-founded than were those of sixteenth century alchemists and leeches in the science of metallurgy or medicine.

Let’s start with the fact that ‘investing’ is one of those undertakings which is simple in concept but very difficult of execution and that it requires effort.

Furthermore, it is a very distinct activity from trading. One may have a great deal of fun – and even make a very nice living – trading, once one understands that trading is as little about the ‘fundamentals’ of economies or businesses being traded as poker is about the specific cards one draws in a hand. But he should also know that investing is a longer game where the idea is to buy something valuable to which the market has temporarily attached too low a price, that the market often does exactly that – and hence that the classic ideas of ‘efficiency’ and ‘rationality’ are an exploitable artefact of academic vanity.

He should know, ultimately, that only entrepreneurs create wealth and that, short of being an entrepreneur himself, he should look for market-given opportunities to invest in other men and women who are, when he can do so at what he reckons is a discount to their likely potential to generate income. He should always bear in mind that genuine entrepreneurs are THE ‘active managers’, THE ‘generators of alpha’ to whom he needs to entrust his hard-earned money above all others.

I’m not sure I would presume to offer any different advice to a young man from the developing, as opposed to the developed world, except to urge that he pay lots of attention to what might be lucrative gaps between what goes on in his country and what we in the West do in ours and also that he resolves to learn not just from what we do well, but from what we do badly!

As for the call to indulge in futurology, that really is a fool’s game. Life moves too fast to be overly specific. In a Heraclitan universe of flux, the straight edge with which one extrapolates an existing trend is the most dangerous instrument in one’s tool kit.

All I can say is that, despite the age-old Malthusian pessimism which is currently enjoying such a vogue, I doubt we will run out of energy – or any other service provided by a material resource – on any foreseeable horizon, though politics and the cult of Gaia might make it seem that way. While I am resolutely despairing of the ability of or the incentive for politicians to make the right choices on any kind of consistent basis, but I am also quietly optimistic of the ability of the man in the street to find his way around the obstacles their incompetence and venality erect in front of him.

10. End Game

You have repeatedly stated that the “markets are broken” (something Zero Hedge agrees with and states daily). We would also add that most governments in the developed world are also broken. Previously we asked you what advice you would give to a 25 year old. Now we are asking you to comment on how you see this deleveraging cycle, superimposed on broken markets, and governments playing out over the next 5 -15 years. We speculate that part of what the monetary authorities in the developed world are trying to do is create a soft landing for western countries living standards, we wonder if this is a possible or even probable outcome?

Answer: There is a glimmer of a chance that we manage to spend the next ten years reliving a version of the past ten just as the authorities hope we will– a glimmer which avoids the question of whether any such remission of sentence would actually redound to our long-term benefit.

There is a slightly greater chance that in desperately trying to avoid a re-run of what our urban mythology tells us what went wrong in the 1930s, the misreading of what went wrong (especially in Depression America) is such that we actually condemn ourselves to enduring a repeat. I would say here that, eighty years ago, it took an almost uninterrupted succession of poor choices and the interplay of any number of aggravating factors to lead us into that particular Valley of the Shadow, that, to rejig the great cliché of those days, the only thing we have to fear is the fear of that fear itself.

There is a somewhat greater chance under the current institutional framework– but still a long odds shot – of moving straight to an episode of accelerating inflation, even of hyperinflation, as people lose all faith in their money and in the aims of those who manage it. The saving grace here is that such behaviour usually has to be learned over a period of time, unless policy is so determinedly and nakedly pointed in that direction, that we still have time to avoid this possibility.

Therefore, by a process of elimination, the scenario to which I would attach the greatest probability to is the one under which we slowly and successively ratchet ourselves up from one level of underemployment and overinflation to the neat, much as we did in the period from 1965-1983. This implies we become locked into a dreadful hysteresis of ever more desperate monetary fixes for wilfully unaddressed real-side problems and that this does then end up teaching people to anticipate the price inflationary side effects and to ignore the transient growth impulses at an earlier and earlier stage in each cycle of ‘stimulus’ to the point at which it is their own attempt at self-preservation which delivers all but the lucky or politically sheltered few into the jaws of this vast meat-grinder of wealth.

Somewhere along the line, we are going to have to recognise the losses we suffered in the Boom. The question is how unfairly those losses will be distributed, how much worse they will be made by our attempts to avoid them, and whether we will re-equilibrate the value of our outstanding obligations with our ability to generate the income to service and then discharge them by (a) pushing the monetary value of the assets up to those of the debts (as has been the thrust of policy to this point); (b) by writing the debt down to the worth of the underlying (a reckoning we have wasted so many trillions trying to avoid); or (c) by being lucky enough to hit upon enough new sources of income to be able to treat the overhang as a minor balancing item (the unspoken hope behind all that has happened these last four years).

Each of these outcomes has different consequences for different classes of investible assets, for different countries, for different industries, and for different companies within them. The trick will be to recognise which path we are indeed following sufficiently early to buy into it at a good price and then to identify where along that route the deepest pitfalls and most desirable prizes lie so as to keep our real wealth intact as far down it as we can.

Good luck with the challenge!

This chapter from Human Action is spot on for today:

Part 4, Chapter XVII.
INDIRECT EXCHANGE

18. The Inflationist View of History

A very popular doctrine maintains that progressive lowering of the monetary unit’s purchasing power played a decisive role in historical evolution. It is asserted that mankind would not have reached its present state of well-being if the supply of money had not increased to a greater extent than the demand for money. The resulting fall in purchasing power, it is said, was a necessary condition of economic progress. The intensification of the division of labor and the continuous growth of capital accumulation, which have centupled the productivity of labor, could ensue only in a world of progressive price rises. Inflation creates prosperity and wealth; deflation distress and economic decay.[25] A survey of political literature and of the ideas that guided for centuries the monetary and credit policies of the nations reveals that this opinion is almost generally accepted. In spite of all warnings on the part of economists it is still today the core of the layman’s economic philosophy. It is no less the essence of the teachings of Lord Keynes and his disciples in both hemispheres.

The popularity of inflationism is in great part due to deep-rooted hatred of creditors. Inflation is considered just because it favors debtors at the expense of creditors. However, the inflationist view of history which we have to deal with in this section is only loosely related to this anticreditor argument. Its assertion that “expansionism” is the driving force of economic progress and that “restrictionism” is the worst of all evils is mainly based on other arguments.

It is obvious that the problems raised by the inflationist doctrine cannot be solved by a recourse to the teachings of historical experience. It is beyond doubt that the history or prices shows, by and large, a continuous, although sometimes for short periods interrupted, upward trend. It is of course impossible to establish this fact otherwise than by historical understanding. Catallactic precision cannot be applied to historical problems. The endeavors of some historians and statisticians to trace back the changes in the purchasing power of the precious metals for centuries, and to measure them, are futile. It has been shown already that all attempts to measure economic magnitudes are based on entirely fallacious assumptions and display ignorance of the fundamental principles both of economics and of history. But what history by means of its specific methods can tell us in this field is enough to justify the assertion that the purchasing power of money has for centuries shown a tendency to fall. With regard to this point all people agree.

But this is not the problem to be elucidated. The question is whether the fall in purchasing power was or was not an indispensable factor in the evolution which led from the poverty of ages gone by to the more satisfactory conditions of modern Western capitalism. This question must be answered without reference to the historical experience, which can be and always is interpreted in different ways, and to which supporters and adversaries of every theory and of every explanation of history refer as a proof of their mutually contradictory and incompatible statements. What is needed is a clarification of the effects of changes in purchasing power on the division of labor, the accumulation of capital, and technological improvement.

In dealing with this problem one cannot satisfy oneself with the refutation of the arguments advanced by the inflationists in support of their thesis. The absurdity of these arguments is so manifest that their refutation and exposure is easy indeed. From its very beginnings economics has shown again and again that assertions concerning the alleged blessings of an abundance of money and the alleged disasters of a scarcity of money are the outcome of crass errors in reasoning. The endeavors of the apostles of inflationism and expansionism to refute the correctness of the economists’ teachings have failed utterly.

The only relevant question is this: Is it possible or not to lower the rate of interest lastingly by means of credit expansion? This problem will tb treated exhaustively in the chapter dealing with the interconnection between the money relation and the rate of interest. There it will be shown what the consequences of booms created by credit expansion must be.

But we must ask ourselves at this point of our inquiries whether it is not possible that there are other reasons which could be advanced in favor of the inflationary interpretation of history. Is it not possible that the champions of inflation have neglected to resort to some valid arguments which could support their stand? It is certainly necessary to approach the issue from every possible avenue.

Let us think of a world in which the quantity of money is rigid. At an early stage of history the inhabitants of this world have produced the whole quantity of the commodity employed for the monetary service which can possibly be produced. A further increase in the quantity of money is out of the question. Fiduciary media are unknown. All money-substitutes–the subsidiary coins included–are money-certificates.

On these assumptions the intensification of the division of labor, the evolution from the economic self-sufficiency of households, villages, districts, and countries to the world-embracing market system of the nineteenth century, the progressive accumulation of capital, and the improvement of technological methods of production would have resulted in a continuous trend toward falling prices. Would such a rise in the purchasing power of the monetary unit have stopped the evolution of capitalism?

The average businessman will answer this question in the affirmative. Living and acting in an environment in which a slow but continuous fall in the monetary unit’s purchasing power is deemed normal, necessary, and beneficial, he simply cannot comprehend a different state of affairs. He associates the notions of rising prices and profits on the one hand and of falling prices and losses on the other. The fact that there are bear operations too and that great fortunes have been made by bears does not shake his dogmatism. These are, he says, merely speculative transactions of people eager to profit from the fall in the prices of goods already produced and available. Creative innovations, new investments, and the application of improved technological methods require the inducement brought about by the expectation of price rises. Economic progress is possible only in a world of rising prices.

This opinion is untenable. In a world of a rising purchasing power of the monetary unit everybody’s mode of thinking would have adjusted itself to this state of affairs, just as in our actual world it has adjusted itself to a falling purchasing power of the monetary unit. Today everybody is prepared to consider a rise in his nominal or monetary income as an improvement of his material well-being. People’s attention is directed more toward the rise in nominal wage rates and the money equivalent of wealth than to the increase in the supply of commodities. In a world of rising purchasing power for the monetary unit they would concern themselves more with the fall in living costs. This would bring into clearer relief the fact that economic progress consists primarily in making the amenities of life more easily accessible.

In the conduct of business, reflections concerning the secular trend of prices do not bother any role whatever. Entrepreneurs and investors do not bother about secular trends. What guides their actions is their opinion about the movement of prices in the coming weeks, months. or at most years. They do not heed the general movement of all prices. What matters for them is the existence of discrepancies between the prices of the complementary factors of production and the anticipated prices of the products. No businessman embarks upon a definite production project because he believes that the prices, i.e., the prices of all goods and services, will rise. He engages himself if he believes that he can profit from a difference between the prices of goods of various orders. In a world with a secular tendency toward falling prices, such opportunities for earning profit will appear in the same way in which they appear in a world with a secular trend toward rising prices. The expectation of a general progressive upward movement of all prices does not bring about intensified production and improvement in well-being. It results in the “flight to real values,” in the crack-up boom and the complete breakdown of the monetary system.

If the opinion that the prices of all commodities will drop becomes general, the short-term market rate of interest is lowered by the amount of the negative price premium.[26] Thus the entrepreneur employing borrowed funds is secured against the consequences of such a drop in prices to the same extent to which, under conditions of rising prices, the lender is secured through the price premium against the consequences of falling purchasing power.

A secular tendency toward a rise in the monetary unit’s purchasing power would require rules of thumb on the part of businessmen and investors other than those developed under the secular tendency toward a fall in its purchasing power. But it would certainly not influence substantially the course of economic affairs. It would not remove the urge of people to improve their material well-being as far as possible by an appropriate arrangement of production. It would not deprive the economic system of the factors making for material improvement, namely, the striving of enterprising promoters after profit and the readiness of the public to buy those commodities which are apt to provide them the greatest satisfaction at the lowest costs.

Such observations are certainly not a plea for a policy of deflation. They imply merely a refutation of the ineradicable inflationist fables. They unmask the illusiveness of Lord Keynes’s doctrine that the source of poverty and distress, of depression of trade, and of unemployment is to be seen in a “contractionist pressure.” It is not true that “a deflationary pressure … would have … prevented the development of modern industry.” It is not true that credit expansion brings about the “miracle … of turning a stone into bread.”[27]

Economics recommends neither inflationary not deflationary policy. It does not urge the governments to tamper with the market’s choice of a medium of exchange. It establishes only the following truths:

1. By committing itself to an inflationary or deflationary policy a government does not promote the public welfare, the commonweal, or the interests of the whole nation. It merely favors one or several groups of the population at the expense of other groups.

2. It is impossible to know in advance which group will be favored by a definite inflationary or deflationary measure and to what extent. These effects depend on the whole complex of the market data involved. They also depend largely on the speed of the inflationary or deflationary movements and may be completely reversed with the progress of these movements.

3. At any rate, a monetary expansion results in misinvestment of capital and overconsumption. It leaves the nation as a whole poorer, not richer. These problems are dealt with in Chapter XX.

4. Continued inflation must finally end in the crack-up boom, the complete breakdown of the currency system.

5. Deflationary policy is costly for the treasury and unpopular with the masses. But inflationary policy is a boon for the treasury and very popular with the ignorant. Practically, the danger of deflation is but slight and the danger of inflation tremendous.

[25]. Cf. the critical study of Marianne von Herzfeld, “Die Geschichte als Funktion der Geldbewegung,” Archiv fuer Sozialwissenschaft, LVI, 654-686, and the writings quoted in this study.

[26]. Cf. below, pp. 541-545.

[27]. Quoted from: International Clearing Union, Text of a Paper Containing Proposals by British Experts for an International Clearing Union, April 8, 1943 (published by British Information Services, an Agency of the British Government), p. 12.